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Unformatted text preview: TBS 907 Financial Strategy AUTUMN 2005 Course Objective
TBS907 gives an overview of financial strategy, outlines the importance of achieving a sustainable competitive advantage and introduce the fundamental principle on which successful financial strategies depend: the separation of business and financial risk. MODULE 1 Course Introduction: Links to TBS901, overview of the program, key financial corporate objectives, financial markets and the corporation. Fundamentals of Present Value and NPV decisions Financial Reporting and Capital Markets
Savings Information Intermediaries Financial Intermediaries Business Ideas From Business Activities to Financial Statements Managing Resources, Activities and People An organisation . . . Directing Decision Making acquires resources Organised set of activities
Controlling Planning hires people From Business Activities to Financial Statements The Accounting Process
Identification Transactions Measurement Quantification in money terms Recording Recording; classification; summarisation Communication Analysis and interpretation Accounting reports Role of Financial Management
Executives are expected to: Formulate financial strategies that are appropriate to corporate and business unit strategies Establish systems that enable firms to interpret their competitive environment Financial Strategy Financial Strategy can be defined as:
"Raising the funds required by the organization in the manner most appropriate to its overall corporate and competitive strategies, and also managing the use of those funds within the organization" Principal aspects of financial strategy The optimum mix of investor The way in which they perceive risk involved The alternative methods of giving them their desired return Risk vs Return
Increased Risk must be compensated by higher level of return An organization can only achieve a more than satisfactory return for its investors by identifying the imperfections in the markets in which it operates The major objective of corporate and business strategies is to develop a sustainable competitive advantage, which enables the organization to achieve and maintain a return in excess of that which would be possible in a perfectly competitive market. Increasing Shareholder Value This can only be done if NPV is positive Business and Financial Risk
Successful financial strategies depend on the separation of business and financial risk. Business Risk This is the inherent risk associated with the underlying nature of the particular business and the specific competitive strategy. A new, focused, single product, high technology organization (for example in the genetic engineering industry) would have a very high intrinsic business risk. Financial Risk This is the risk that arises when a firm employs fixedcost financing such as debt, preferred stock or leases. This risk is borne by the common stock holders As a result of this additional financial risk they demand a higher expected return. Financial Risk
When considering financial risk it is essential to decide from which perspective the analysis is being made, since financial risk can be described as two sides of the same coin:
Type of funding Debt Equity Risk to provider Risk to Organization Low (Bank) High High (shareholder) Low Developing Financial Strategy Developing logical financial strategies for different types of companies can be done by combining the concept of financial risk with business risk Business Risk Vs Financial Risk the different combinations High business/High financial High business/Low financial Low Business/ Low Financial Low Business/High Financial Financial Decisions
Major financial decisions are: investment decisions -- decisions that determine the asset profile of a business (amount and composition of investments) financing decisions -- how the assets are to be funded (debt and equity) financing decisions also involve dividend decisions The Finance Function: Major Roles of Financial Managers Project evaluation Evaluating, obtaining and servicing short and longterm financing Dividend distributions Collection and custody of cash and payment of bills Management of investments in current assets The Finance Function: Major Roles of Financial Managers (cont.) Assessing the viability of growth through acquisitions Planning the future development of the business Interest rate and exchange rate risk management Development and implementation of financial policies A Company's Financial Objective
The maximisation of market value of a company's shares is the overriding objective. Basic Concepts of Finance
Value The value of a company (V ) on the financial markets may be expressed as : Financial markets will value debt and equity, taking into account the risk and expected return from investing in these securities. V = D + E where D = the value of debt E = the value of equity Basic Concepts of Finance (cont.)
Time and Uncertainty The value of an investment will depend on the amount and timing of the cash flows generated by the investment. Time value of money: a dollar today is worth more than a dollar in the future. Basic Concepts of Finance (cont.)
Nominal and Real Amounts The cost of an asset expressed as the number of dollars paid to acquire the asset is the nominal price. However, due to inflation and deflation, the purchasing power of money changes. Therefore, it is necessary to distinguish between the nominal or face value of money and the real or inflationadjusted value of money. Basic Concepts of Finance (cont.)
Market Efficiency and Asset Pricing Market efficiency means that we should expect securities and other assets to be fairly priced, given their expected risks and returns. Tradeoff between risk and expected return under the capital asset pricing model (CAPM): Systematic risk: marketwide factors (nondiversifiable or market risk). Unsystematic risk: factors that are specific to a particular company (diversifiable or unique risk). According to the CAPM, investors can diversify their investments to eliminate unsystematic risk. Basic Concepts of Finance (cont.) Arbitrage If two identical assets were to trade in the same market at the same time at different prices, and if there were no transaction costs, then an arbitrage opportunity would exist. A riskfree profit could be made by simultaneously purchasing at the lower price and selling at the higher price. However, competition among traders will force the two alternative prices to become the same. Arbitrage precludes perfect substitutes from selling at different prices in the same market. Basic Concepts of Finance (cont.)
Agency Relationships One party, the principal, delegates decisionmaking authority to another party, the agent. In a company: managers = agents shareholders = principals Basic Concepts of Finance (cont.)
Agency Relationships (cont.) Agency costs: conflict of interest between parties creates costs
reduced value due to managers acting in their own best interests costs associated with monitoring managers' behaviour bonding costs Agency Costs
Agency costs arise from the potential for conflicts of interest between the parties forming the contractual relationships of the firm. Management may make decisions that transfer wealth from lenders to shareholders. Sources of potential conflict: claim dilution dividend payout asset substitution underinvestment Agency Costs (cont.)
Claim Dilution A company may issue new debt which ranks higher than existing debt. Holders of the old debt now have a less secure claim on the company's assets. Wealth can be transferred from the holders of the old debt to shareholders. Agency Costs (cont.)
Dividend Payout A company may significantly increase its dividend payout. This decreases the company's assets and increases the riskiness of its debt. Again, this results in a wealth transfer from lenders to shareholders. Agency Costs (cont.)
Asset Substitution A company's incentive to undertake risky investments increases because of the use of debt. If risky investments prove successful, most of the benefits will flow to shareholders, but if it fails, most of the costs will be borne by lenders. Undertaking such investments (negative NPV) causes the total value of the company to decrease, but the value of the shares will increase and the value of the debt will fall. Agency Costs (cont.)
Underinvestment: A company may reject proposed lowrisk investments which have a positive net present value. If a company's debt is very risky it may not be in the interest of shareholders to contribute additional capital to finance new investments. Although the investment is profitable, shareholders may lose because the risk of the debt will fall and its value will increase. Agency Costs (cont.)
Potential conflict of interest between lenders and shareholders, and the likelihood of conflict increases with greater financial leverage. Costs borne by shareholders higher interest rates, restrictive covenants Agency Costs (cont.)
Conflicts of interest between shareholders and managers. Can be reduced by aligning the objectives of managers with those of shareholders: employee share ownership schemes remuneration for toplevel managers in the form of options Management Incentive Schemes These are in place in many large organizations to increase shareholder value. These schemes allow managers to to buy companies shares in the future at a price fixed now. This is an attempt at goal congruence between management and shareholders. However, this may not take place. However, this may not take place: Managers are given share options, shareholders pay for them If funds are retained in the business capital appreciation will form a larger proportion of total return. This benefits managers and not shareholders who want dividends. If the share price falls managers will not exercise the option, whereas investors will make a loss. Agency Costs (cont.)
Would it be best to eliminate the costs associated with the separation of ownership and control by having a company's equity capital provided only by its managers? Few individuals have the combination of wealth and skills NO to both own and manage a company involved in activities such as largescale industrial operations. While uniting the functions of management and provision of capital has advantages in terms of agency costs, it has disadvantages in terms of risk bearing (investors can easily diversify by simply combining the shares of many companies in a portfolio). Managers and Shareholder Interests Tools to Ensure Management Pays Attention to the Value of the Firm Manager's actions are subject to the scrutiny of the board of directors. Shirkers are likely to find they are ousted by more energetic managers. Financial incentives such as stock options Investors' Reactions To Managers' Decisions A company's managers make an investment, financing or dividend decision. Information about this decision is transmitted to investors. Investors may adjust their expectations of future returns from an investment and revise their valuation of the company's shares. Investors compare the market price with their revised valuation and either buy or sell shares in the company. Investors' Reactions To Managers' Decisions (cont.)
Certainty If managers knew with certainty an investment's cash flows, they would know its NPV. All investors would also know the NPV of the investment and there would be an immediate increase in the price of the company's shares. Uncertainty In practice, there is uncertainty. The effect on the share price of decisions made by managers is no longer perfectly predictable. A simplification is to assume that the share price will adjust immediately to reflect the new best estimate of the `true' value of the company. Empirical evidence suggests investors react quickly to the receipt of new information with this information being reflected in security prices. Investors' Reactions To Managers' Decisions (cont.) INTRODUCTION TO PV AND NPV
Present Value Value today of a future cash flow. Discount Rate Interest rate used to compute present values of future cash flows. Discount Factor Present value of a $1 future payment. Present Value Present Value = PV PV = discount factor C1 Present Value
Discount Factor = DF = PV of $1 DF = 1 t (1+ r ) Discount Factors can be used to compute the present value of any cash flow. Present Values
C1 PV = DF C1 = 1 + r1
DF =
1 (1+ r ) t Discount Factors can be used to compute the present value of any cash flow. Present Values Ct PV = DF C t = t (1 + r ) Replacing "1" with "t" allows the formula to be used for cash flows that exist at any point in time Valuing an Office Building
Step 1: Forecast cash flows Cost of building = C0 = 350 Sale price in Year 1 = C1 = 400 Step 2: Estimate opportunity cost of capital If equally risky investments in the capital market offer a return of 7%, then Cost of capital = r = 7% Valuing an Office Building
Step 3: Discount future cash flows PV = C1 (1+ r ) = 400 (1+ .07 ) = 374 Step 4: Go ahead if PV of payoff exceeds investment NPV = - 350 + 374 = 24 Net Present Value
NPV = PV - required investment C1 NPV = C0 + 1+ r Risk and Present Value Higher risk projects require a higher rate of return Higher required rates of return cause lower PVs PV of C1 = $400 at 7% 400 PV = = 374 1 + .07 Risk and Present Value
PV of C1 = $400 at 12% 400 PV = = 357 1 + .12 PV of C1 = $400 at 7% 400 PV = = 374 1 + .07 Rate of Return Rule Accept investments that offer rates of return in excess of their opportunity cost of capital Rate of Return Rule Accept investments that offer rates of return in excess of their opportunity cost of capital Example
In the project listed below, the foregone investment opportunity is 12%. Should we do the project?
profit 400,000 - 350,000 Return = = = .143 or 14.3% investment 350,000 Net Present Value Rule Accept investments that have positive net present value Net Present Value Rule Accept investments that have positive net present value
Example Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 10% expected return? 60 NPV = -50 + = $4.55 1.10 Opportunity Cost of Capital
Example You may invest $100,000 today. Depending on the state of the economy, you may get one of three possible cash payoffs: Economy Payoff Slump Normal Boom $80,000 110,000 140,000 80,000 + 110,000 + 140,000 Expected payoff = C1 = = $110,000 3 Opportunity Cost of Capital
Example continued The stock is trading for $95.65. Next year's price, given a normal economy, is forecast at $110 Opportunity Cost of Capital
Example continued The stocks expected payoff leads to an expected return. expected profit 110 - 95.65 Expected return = = = .15 or 15% investment 95.65 Opportunity Cost of Capital
Example continued Discounting the expected payoff at the expected return leads to the PV of the project 110,000 PV = = $95,650 1.15 Present Values
Example You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years? Present Values
Example You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years? PV = 3000 (1.08 ) 2 = $2,572.02 Present Values PVs can be added together to evaluate multiple cash flows. PV = C1 (1+ r )
1 + (1+r ) 2 +....
C2 Present Values Given two dollars, one received a year from now and the other two years from now, the value of each is commonly called the Discount Factor. Assume r1 = 20% and r2 = 7%. Present Values Given two dollars, one received a year from now and the other two years from now, the value of each is commonly called the Discount Factor. Assume r1 = 20% and r2 = 7%. DF1 = DF2 = 1.00 (1+.20 )1 1.00 (1+.07 ) 2 = .83 = .87 Present Values
Example Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value. Year 0 Year 1 Year 2 - 150,000 - 100,000 + 300,000 Present Values
Example continued
Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value. Period 0 1 2 Discount Factor 1.0 1 1.07 = .935
1 ( 1.07 ) 2 Cash Flow - 150,000 - 100,000 Present Value - 150,000 - 93,500 = .873 + 300,000 + 261,900 NPV = Total = $18,400 Short Cuts Sometimes there are shortcuts that make it very easy to calculate the present value of an asset that pays off in different periods. These tolls allow us to cut through the calculations quickly. Short Cuts
Perpetuity Financial concept in which a cash flow is theoretically received forever. cash flow Return = present value C r= PV Short Cuts
Perpetuity Financial concept in which a cash flow is theoretically received forever. cash flow PV of Cash Flow = discount rate C1 PV = r Short Cuts
Annuity An asset that pays a fixed sum each year for a specified number of years. Short Cuts
Annuity An asset that pays a fixed sum each year for a specified number of years. 1 1 PV of annuity = C - t r r (1 + r ) Annuity Short Cut
Example You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease? Annuity Short Cut
Example continued
You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease? 1 1 Lease Cost = 300 - 48 .005 .005(1 + .005) Cost = $12,774.10 Inflation
Inflation Rate at which prices as a whole are increasing. Nominal Interest Rate Rate at which money invested grows. Real Interest Rate Rate at which the purchasing power of an investment increases. Stocks & Stock Market
Common Stock Ownership shares in a publicly held corporation. Secondary Market market in which already issued securities are traded by investors. Dividend Periodic cash distribution from the firm to the shareholders. P/E Ratio Price per share divided by earnings per share. Stocks & Stock Market
Book Value Net worth of the firm according to the balance sheet. Liquidation Value Net proceeds that would be realized by selling the firm's assets and paying off its creditors. Market Value Balance Sheet Financial statement that uses market value of assets and liabilities. Valuing Common Stocks
Expected Return The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the market capitalization rate. Div1 + P1 - P0 Expected Return = r = P0 Valuing Common Stocks
Example: If Fledgling Electronics is selling for $100 per share today and is expected to sell for $110 one year from now, what is the expected return if the dividend one year from now is forecasted to be $5.00? 5 + 110 - 100 Expected Return = = .15 100 Valuing Common Stocks
The formula can be broken into two parts. Dividend Yield + Capital Appreciation Div1 P - P0 Expected Return = r = + 1 P0 P0 Valuing Common Stocks
Capitalization Rate can be estimated using the perpetuity formula, given minor algebraic manipulation. Div1 Capitalization Rate = P0 = r-g Div1 =r= +g P0 Valuing Common Stocks
Return Measurements Div1 Dividend Yield = P0 Return on Equity = ROE EPS ROE = Book Equity Per Share Valuing Common Stocks
Dividend Discount Model Computation of today's stock price which states that share value equals the present value of all expected future dividends. Valuing Common Stocks
Dividend Discount Model Computation of today's stock price which states that share value equals the present value of all expected future dividends. Div1 Div2 Div H + PH P0 = + +...+ 1 2 H (1 + r ) (1 + r ) (1 + r )
H Time horizon for your investment. Valuing Common Stocks Valuing Common Stocks
Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return? Valuing Common Stocks
Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return? 3.00 3.24 350 + 94.48 . PV = + + 1 2 3 (1+.12) (1+.12) (1+.12) PV = $75.00 Valuing Common Stocks
If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY. Valuing Common Stocks
If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY. Div1 EPS1 Perpetuity = P0 = or r r
Assumes all earnings are paid to shareholders. Valuing Common Stocks
Constant Growth DDM A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model). Valuing Common Stocks
Example continued If the same stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends? $3.00 $100 = .12 - g g =.09 Answer The market is assuming the dividend will grow at 9% per year, indefinitely. Valuing Common Stocks If a firm elects to pay a lower dividend, and reinvest the funds, the stock price may increase because future dividends may be higher. Payout Ratio Fraction of earnings paid out as dividends Plowback Ratio Fraction of earnings retained by the firm. Valuing Common Stocks
Growth can be derived from applying the return on equity to the percentage of earnings plowed back into operations. g = return on equity X plowback ratio Valuing Common Stocks
Example Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. Instead, we decide to plow back 40% of the earnings at the firm's current return on equity of 20%. What is the value of the stock before and after the plowback decision? Valuing Common Stocks
Example Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. Instead, we decide to blow back 40% of the earnings at the firm's current return on equity of 20%. What is the value of the stock before and after the plowback decision? No Growth With Growth 5 P0 = = $41.67 .12 Valuing Common Stocks
Example Our company forecasts to pay a $5.00 dividend next year, which represents 100% of its earnings. This will provide investors with a 12% expected return. Instead, we decide to blow back 40% of the earnings at the firm's current return on equity of 20%. What is the value of the stock before and after the plowback decision? No Growth With Growth 5 P0 = = $41.67 .12 g =.20.40 =.08 3 P0 = = $75.00 .12 -.08 Valuing Common Stocks
Example continued If the company did not plowback some earnings, the stock price would remain at $41.67. With the plowback, the price rose to $75.00. The difference between these two numbers (75.0041.67=33.33) is called the Present Value of Growth Opportunities (PVGO). Valuing Common Stocks
Present Value of Growth Opportunities (PVGO) Net present value of a firm's future investments. Sustainable Growth Rate Steady rate at which a firm can grow: plowback ratio X return on equity. Summary
Business entities include sole proprietorship, partnership and company. We focus on public companies. We study corporate finance along with investments and the structure of financial markets and institutions. We consider broad finance issues such as valuations, market efficiency, asset pricing and arbitrage, along with agency issues. Summary
How can diverse investors all be satisfied with the decisions of management? Companies should maximise shareholder wealth and let shareholders use the capital market to allocate this wealth over time. Company and shareholders decisions are separate. ...
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